Investment Environment
This pages is not investment advice. The authors are not responsible for any losses arising from following any strategies described on this page. All investment advice must take into account the personal circumstances of the investor. The authors of this page do not know the circumstances of any person reading this page so are not in a position to offer advice, even if licenced to do so, which they do not claim to be. There are many macro considerations to investment. This article notes and overviews some of them. Each is worthy of separate page. __TOC__ Introduction Investing at the top is a disaster There is virtually no point investing at the top of a bull market. Even the best performing sectors, economies and stocks fall during any significant global bear market. Even if some were not to fall, is there any reason to believe that you are the person who can pick them against the 10s or even 100s of thousands of professional economists and analysts? Analyst buy and hold recommendations are highly unlikely to perform positively in a bear market. There are few examples of analysts correctly issuing a buy or hold recommendation during a bear market. It is up to you alone Even after dramatic bull and bear markets, so called conservative managed funds do not generally dramatically rebalance their portfolios from aggressive to defensive assets or vice versa, although they may rebalance their portfolios as described much further below. They maintain their declared stance quite consistently. You can't rely on the fund manager to save you. (Actively managed hedge funds and black box funds may be an exception to this but they have their own risks which are beyond the current scope of this article) When the shape of the yield curve changes or moving averages cross, you need to decide whether to change asset allocation by switching between funds or between options with a fund. Picking major transitions Once a short term moving average (eg 10 to 30 days) crosses below a longer term moving average (eg 60 to 100 days) (try Incredible Charts as a way of seeing such averages) from above there is a about a one in two probability that a major bear market has started, based on examination of past trends. It is a good time to consider dramatically reducing exposure to shares or buying some form of protection against widespread falls in value. While there is about a one in two chance of being whipsawn (the averages soon cross back indicating a possible major bull period and requiring you to buy back in at prices higher than those at which you sold) the loss of opportunity from being whipsawn using such long moving averages is only about 10 to 20% of the loss that can occur in a major bear market. Unfortunately nothing is fool proof every time and the falls in 1974 were so fast and short lived that you probably would have got out at the bottom when the 20 went below the 100 and then missed the rebound until it was about half over and the 20 went above the 100. Monitoring you must do Every person with an investment portfolio exposed to shares whether directly, through managed funds, superannuation or other retirement savings products (eg 401k) should spend an hour a week # looking at the shape of the yield curve compared to a month ago - is it moving toward or has it become inverse (moving towards inverse is a warning of possible future falls in the price of shares and a housing slow down). If it is becoming more steeply normal (normal is the opposite of inverse) as a result of interest rate cuts during a downturn it is an indicator that there might be a major buying opportunity within a 1 to 20 months and it is time to consider when you should start pursuing a dollar cost average investment strategy. It warns it is nearly time to unwind any short positions. # checking charts with short and long term moving averages of major country and sector indices. You need two sets of moving averages, one set to warn you to move to checking every second day, the other set as your pre-determined action point If the shape of the yield curve has changed from normal to inverse of vice versa or your "warning" averages cross you need to spend half an hour at least every second day watching for your pre-determined action signals. This could have to be done over a period of many months. If you have a large portfolio it is likely to be well worth while. If your portfolio is only a few thousand but likely to grow because you are young with a good income, you should do it anyway for practice and discipline that you will need later. You need to then consider whether there are signs for a need to change asset allocation between aggressive (share) and defensive investments (short term cash at AAA or AA+ rated government regulated banks and short term government securities). More sophisticated and active investors should consider entering into other defensive arrangements (eg buy put options, short the major index). Aggressive active investors with an appetite for high risk could consider going short on a net basis, but with protection against a dramatic rise in markets. Economic cycle Yield curve A yield curve is a plot of the interest rates for loan securities issued by the same person for different maturities eg 3 months, 6 months, 1 year, 3 years, 5, 10, 20 and 30 years. Normally longer term interest rates are higher than short term interest rates. When short term rates are higher than long term rates the yield curve is described as inverted or inverse. An inverse yield curve often leads to an economic downturn and/or falls in stock markets. See the animated yield curve at Stockcharts and watch how it is inverse in 2001 as the market peaks and then starts to fall significantly, gets normal in mid 2001 after the market has fallen significantly and the Fed eases, steeply normal in late 2002 early 2003 as recession bites. The market starts to rise and the yield curve moves up and gets less steep as the Fed tightens slightly, but goes inverse in mid to late 2006. The crash followed within about 15 months of the curve turning consistently inverse. Market cycle Are you proposing to invest after 10 consecutive years of growth or has there recently been a 50% fall in markets. Which is the riskier time to invest? Has the great balance of economic news been very good for a long time? Is there lots of "It's different this time because...." opinion? Inventory cycle When sales slow at unexpected times of the year inventories build as forward orders have been based on a higher level of sales. When stock inventories begin to grow as a percentage of estimated short term future sales, not only are orders reduced, but carrying levels are reduced in absolute terms to meet the new lower level of sales. This de-stocking causes a slump in manufacturing, often requiring manufacturers to enforce production holidays or to close less economic plants and lay off workers. Economic activity cannot pick up until de-stocking is complete. Vacancy rates If vacancy rates are rising then stocks are likely to be too high to allow recent rates of construction activity to continue. Housing stocks Housing stocks are similar to other stocks. If sales slow, often because interest rates go up and the yield curve inverts to fight inflation, stocks grow and production falls. If there are less new houses being sold there are also likely to be less sales of furniture, appliances, furnishings and less need for transport. If housing and commercial office space stocks are grossly excessive at the same time the danger of recession is dramatically higher. Commercial office space stocks If commercial office space stocks are excessive the same thing happens as for housing stocks. If housing and commercial office space stocks are grossly excessive at the same time the danger of recession is dramatically higher. Construction loan approvals When loan approvals start to increase from a low base it is an indicator that there is likely to be an increase in economic activity in 3 months time. Loan approvals generally only start to fall once excessive stocks have become obvious or the economy has already started to slow (often because of an inverse yield curve) or loan default rates have started to increase on loans written in the last few years because credit standards had been allowed to slip too far (there was an increase in the proportion of sub-prime loans). Building starts Building starts are highly unlikely to increase unless construction loan approvals have already started to increase. Transport activity and rates As economic activity declines transport tonnages and rates decline. When de-stocking is complete, then transport tonnages begin to recover as a flow of goods resumes albeit at lower levels than at the peak. Inflation Are there legislated inflation targets or ranges? Is the central bank independent of government? Is inflation under control and stable within any legislated targets? Australia has a relatively independent central bank with clearly identified inflation targets but the Reserve Bank didn't act strongly enough to keep inflation within the target range, but reacted strongly once it broke above the range, causing a dramatic increase in interest rates which hurt most home owners with mortgages. Do inflation definitions include measures of asset price inflation? Has inflation been very high (>10%) for an extended period of time (>3 years) and prompted high interest rates which have caused a severe recession? If so as interest rates fall then capitalisation multiples will increase leading to potentially large increases in asset prices based on the transition to higher capitalisation multiples. At 10% the capitalisation multiple is 10, at 5% the capitalisation multiple is 20. If the multiple moves from 10 to 20 asset prices with a long income stream double. The same happens if the long term bond rate falls from 4% (x 25) to 2 (x 50). Asset price inflation Most countries eliminate asset price inflation from their measures of inflation. They do this by substituting other measures for house prices. If rents are only rising slowly then reported inflation is low, even if house prices have doubled as a result of credit creation. Credit creation What is the rate of credit creation? How does it compare to the rate of population growth and the rate of inflation? Is it fuelling a boom in asset prices? Rapid credit creation might be sensible in a period of recession, but should reduce steadily once growth is restored, otherwise future stability is undermined and the seeds of the next boom (and bust) are sown. House price affordability Are median house prices an unusually high multiple of median earnings? Credit quality Are companies and people able to borrow more funds easily against recent large increases in real estate values where there has been no rezoning or refurbishment? Are the requirements for saved deposits, documented sources of taxable income, proportions of income which can be borrowed, proof of earnings being relaxed by banks? Asset complexity Are greater proportions of financial assets being packaged in more complex, less transparent ways? Commodity prices Are prices for commodities used in the manufacture of a large proportion of manufactures at record highs? Has the oil price moved to record highs? Oil shocks were relevant in 1974 and 2007. Are commodity stocks low? and are they continuing to reduce or are they now increasing as new mines and wells come on stream or usage declines? Bear Market comparisons Falls and rises A super bear is upon us or A super bear is upon us Ranking bear markets This table is as at 20 Feb 2009 when DJI closed at 7365. It is 7114 on 23 Feb, so this is now the third deepest market fall in 100 years. Strategies Portfolio rebalancing Set an asset allocation between asset classes. EG 20% domestic shares, 20% global shares unhedged, 20% emerging markets unhedged, 20% long term bonds, 20% cash. As some investments increase or decrease in value the actual balances will change, changing your asset allocation. Assets which increased in price will go over their set allocation, assets which underperformed will go under their set allocation. Each say 3 months, rebalance the portfolio back to your set asset allocation percentages. Dollar cost averaging Buy 100 dollars every month whether the market is up or down and irrespective of what you think will happen to the market next month or year Buy and hold Buy quality stocks and never sell them. The share price history of General Motors shows the risk in this approach. Bottom picking Hold out of the market unless you are confident you are around the bottom of a bear market. If you are confident that it is the bottom, buy in big or use dollar cost averaging to reduce risk from further falls. Two adages against this approach are: # it's time in the market, not market timing (but in Feb 09 the market is back almost to 1998 levels) # no one rings a bell at the bottom - there are some times when the market has continued lower even after large falls. Look at a chart of the 1929 to 1932 crash and the bear market that ended in 1942. There are times it has rebounded very rapidly. Look a t a chart of the recovery after the September 1974 crash. The trend is your friend Only invest when there is a consistent uptrend established and bail out if there are xx days/weeks/months of the market closing below your entry price. Stock picking Pick the best stocks and invest in them. Generally this is in the stock market of your own country. This can be done on a "buy and hold" basis or it can be more actively managed. Bottom up approach Find the best stocks and invest in them. It is too hard to understand what will happen in the economy as a whole. Top down approach Find a good economy and invest in it. Most stocks and indices in that economy will do well - but it is a global economy and consider the currency risk Fundamental analysis Fundamental analysis is doing detailed analysis of a large number of companies to identify which are likely to be the best investment Technical analysis See charting Charting Technical analysis is looking at charts for patterns which indicate the likely direction of markets or stocks in the future. Moving averages Look for crosses of moving averages. If the 10 day moving average has been below the 100 day moving average and crosses to be above it then it indicates a reliable uptrend has been established. The higher the number of days in the higher moving average the more of the upturn you are likely to miss. The shorter the moving averages you use the more likely you are to be whipsawn. Currency risk If it is not your home country are you prepared to accept that your return in your home currency will be affected by currency fluctuations. Is your prima facie currency risk hedged? Portfolio effect If you are invested 100% in the shares of 1 company and it goes bad you lose everything. Your risk is relatively high. If you are invested evenly in 10 companies in 10 different sectors of the economy across 10 different countries/currencies your risk (and expected returns over the long term) is low. Asset allocation What proportion of your total assets are in each of cash, stocks, bonds, direct property, collectables, commodities and in what currencies? Should you be diversified across multiple currencies as well as multiple asset classes? Leverage Leverage magnifies the losses and gains. If you borrow 50% to buy an asset worth 100 and it falls 50% you lose 100% of your investment. If it gains 10% and your interest cost is 5% you make 5 on 50 which is 10%, same as if you had no leverage. If it gains 20% and your interest cost is 5% you make 15 on 50 which is 30%. Borrowing against shares is doubly risky as the company in which you are purchasing equity already has borrowings or leveraging. Stock market measures Comparative rates of return with bonds The yield on short term government bonds of a low risk country are normally thought of as the risk free rate of return. If you invest in anything else your risk is increasing so you would expect to get a commensurately higher return over the long term. Shares have more risk so you would expect that capital growth plus yield on shares should exceed the yield on bonds in the long term. The more risk you are taking with any investment, the higher the rate of return you are looking to achieve. If dividend yields on shares are very low compared to bonds then there must be a big expectation of capital growth - this does not always happen eg look at comparative yields of bonds and shares at September 2007 and then look at what happened to capital growth - massive losses. Dividend yields The after tax yield can be compared to the risk free rate of return - short term government paper or for consumers dpeosit rates in AAA rated banks. Price earnings ratios You can't look at PE's in isolation. In isolation they are a virtually meaningless number. The PE ratios ignore the other competing opportunities for funds such as bonds, real estate etc. They ought not be looked at in isolation. The PE is the result of dividing the price by the earnings. Because this is a backward looking measure it does not take into account a dramatic deterioration in earnings that has occurred after balance date. It also does not take into account cash flow, quality of earnings, riskiness of the business or balance sheet structure. The Price to Forward Earnings is a better indicator of the PE at which stocks are actually being bought. Different sectors often have quite different PE's. Mining exploration companies may have huge PE's as they have no significant earnings but may have issued very favourable exploration reports. Loss making companies don't have a meaningful PE as they don't have earnings. In 1974 the price of the market was 7.3 times earnings. In the early 1990s recession for example, earnings fell 25% between 1989 and 1992, but the S&P 500 index rose 23% over the same period. Recent PE's from S&P are 30 September 07 - 19.42, 31 December 07 - 22.19, 31 March 08 - 21.90, 30 June 08 - 24.92, but these are historical backward looking PE's. Check what happened to 3 year interest rates and share prices since then. Capitalisation rates Net tangible asset backing A dangerous measure when asset values are falling and book values have not been adjusted. Valuations supporting recently adjusted book values may be 6 months old by the time audited accounts are released. Net operating cash flow You can only pay debts with cash. Cash can only be earnt, borrowed or raised by selling assets. A company can sell more shares. During a credit squeeze you can't borrow more and are likely to be asked to repay part of outstanding indebtedness. During a stock market crash it becomes difficult to issue new shares except at a significant discount to market. If operations don't produce positive net cash flow and new funds are not available, liquidity crises require assets sales at the worst time in the cycle. Country risk Stage of development Does the country have well developed and stable institutions? Is it a Developed Market or an Emerging Market economy? Morgan Stanley has indices for Emerging Markets as well as for Developed Markets. Some funds specialise in emerging markets. Brazil, Russia, India and China are emerging markets. The US, UK, Germany, Australia are Developed Markets. Market or planned economy? US is a free market economy with relatively small government interference compared to North Korea which is a planned economy. Sovereign debt rating Is sovereign debt finely priced compared to eg the US and Germany? What is the price of a credit default swap for sovereign with 5 and 10 years to maturity? Is previously issued debt stock trading at a big discount to par value reflecting a real risk of default? Has the country ever defaulted eg Russia and Argentina. Political risk Is the country likely to remain politically stable for your investment horizon? Population growth A stable population generally means lower growth rates. Europe and Japan Demographics An aging population generally means lower growth rates. Europe and Japan. Household indebtedness Highly indebted households have limited capacity to borrow and spend more and are highly subject to movements in interest rates - monetary policy. US and UK Government indebtedness What proportion of GDP is government indebtedness? Financial system Are the banks tightly regulated with clear capital adequacy requirements? Are banks required to be widely held? Are banks too big to be bailed out eg Iceland's major bank had grown internationaly and was so big the Iceland government couldn't save it without bankrupting the country? Are there state owned banks that are politically influenced? Investment regulation Is mark to market required for financial assets? Is there an independent securities regulator? Does the regulator have a record of successful enforcement? Are penalties for insider trading significant? Corruption What rating does the country have on the corruption index? Freedom of the press Is there a free press? Is there freedom of information? Budget outcome Does the government sector run an overall surplus or deficit? Wealth distribution Is wealth distribution broader or narrower than the Pareto principle? Current account Does the country have a current account deficit or surplus? Balance of trade Does the country export more than it imports. China does and has a surplus. The US doesn't and has a deficit. Debtor or creditor nation US is a major debtor. China is a major creditor, it holds lots of US bonds. Boom bust cycle Is there a repeated pattern of booms and busts? Country table Category:Investment Category:Finance Category:Stockmarket